During the first nine months of 2009, for every dollar of gross margin the operating expenses less depreciation, pension and restructuring costs ("OPEX") at J.C. Penney (JCP) were 81 cents. But they were $1.29 per one dollar of gross margin for the first nine months of 2013.

According to a pressrelease (Jan15, 2014) J.C. Penney will be closing 33 under-performing stores to result in annual cost savings of approximately $65 million. For nine months ending November 2013 OPEX were $3.11 billion. Other things being equal, in order to bring them back to 81% of gross margin (like in 2009) they should amount to no more than $1.955 billion — which is 63% of the actual level achieved for the nine months ending Nov. 2, 2013. Economies of 37% of OPEX make a tough proposition — if such dramatic measures are undertaken sales must be impacted and then merchandise volume, vendor discounts, etc.

The problem is that rounds of OPEX cutting were already undertaken during Ron Johnson (some details:1, 2) and then Ullman (3). Can the company cut more? Or not and then revival simply depends on increasing sales and gross margin? If the strategy of increasing sales by "restored promo pricing" (which saps gross margin just like "everyday low prices") is not delivering back sales closer to $18 billion mark (rather than the current $12-13 billion), then the current OPEX level burns cash and is not sustainable. And considering the "formidable days" effect described later in this document, "restored promo pricing" by itself might not do. The economy of $65 million is just a drop in the ocean.

***

In 2009 the enterprise value of the company was $5,364 million, a multiple of 0.27 times revenue. But nowadays at $6.99/share the enterprise value is about $6,500 million which delivers an EV/Revenue multiple of 0.54 times - double as compared with 2009.

Is J.C. Penney more valuable in 2014 than in 2009? Certainly not, just look at the numbers below:

The shares are currently priced for perfection although the company could file for bankruptcy.

Visiting Some of the CEO's Statements

Equity Raising

According to a Forbes article (September 2013), "JCPenney announces equity offer hours after CEO Ullman denies need to raise capital." Unless Mr. Ullman did not actually deny it before the fact, then the raising of $786 million in new equity just contradicted his statement.

Vendors' Trust

The same Forbes article reports Mr. Ullman to have said: "Vendors are very supportive, we are paying them on time and have not heard any issues with regard to factors." But some numbers filed by the company seem to contradict this statement. Has J.C. Penney volunteered to increase the amount of outstanding letters of credit (LCs) to the concurrence of 6.6% of net sales?

Vendors require a company to issue LCs in order to make sure payments are made in full and on time for goods or services they delivered. Any significant increase in the amount of LCs issued to vendors is prone to indicate feebler trust from vendors or addition of new vendors which, until the relationship proves flawless, need the comfort provided by the LCs.

According to 10-Ks (2009 to 2013) J.C. Penney issued two categories of LCs:

For imports (goods purchased from abroad). Traditionally they were between 0.11% to 38% of total issued LCs;

For self-insured workers' compensation and general liability claims. Traditionally these were between 62% to 97% of total issued LCs.

Notably, during the last two years total outstanding, LCs grew to $534 million November 2013 vs. $281 million February 2013 vs. $144 million in January 2012.

Why did LCs increase to such an extent? This is not yet disclosed publicly. The Q-3 filing only reports, "As of the end of the third quarter of 2013, we had $534 million in standby and import letters of credit outstanding under the 2013 Credit Facility, the majority of which are standby letters of credit that support our merchandise initiatives and workers' compensation."

Further, LCs as a percentage of sales escalated from 1.2% (2009) to 6.6% (November 2013). The banks issuing the LCs charged an annual interest rate of 1.5% to 3%. If the LCs outstanding on Nov. 2, 2013 ($534 million) were carried for a full year their costs would range between $8$ million and $16 million (maybe less since the LC should have grown gradually within the year to $534 million).

Finally, the revolving credit agreement provides the company with up to $1.85 billion of liquidity (subject to various terms and conditions) of which up to $750 million are reserved for the issuance of LCs. As of November 2013 J.C. Penney had been using $534 million of LCs or 71% of the LC sublimit. In November 2013 the LC sublimit amounted to 9.3% of net sales and the outstanding LCs represented 6.6% of net sales, which is material.

I hope the next conference call (and the company's SEC filings) will disclose:

- The amount of outstanding LCs broken down by constituents;

- Why they have grown to the significance of 6.6% of net sales.

Until a better explanation is provided by the company I reason that the spike in the value of outstanding LCs indicates that at least some vendors grew concerned.

Which is not exactly in line with the CEO's affirmation.

If vendors grow discomforted with J.C. Penney, its turnaround chances become nil.

"Pleased with holiday performance"

Why would a company hold back good numbers instead of disclosing them in detail (just as it did on previous occasions)?

Rather, J.C. Penny missed the chance of a significant revival during the holiday season. The CEO buys time to take it to the vendors and convince them that things could be managed and the turnaround can succeed.

Formidable Days

Bad economics dent J.C. Penney's business model

J. C. Penney's business model suffers from:

1 - No pricing power. The company sells commodity merchandise, and retailers like J.C. Penney are many, and active in multiple channels. They compete heavily on price (they sell commodities), and customers are able to and do pick the same merchandise among them efficiently (online comparison, bargain hunting, etc.),

3 - No true differentiation. Mimicking abounds. Nothing J.C. Penney does well cannot be quickly replicated by its competitors: product range, merchandising, whatever. What are J.C. Penney's exclusive products or channels so that customers will go to it alone to make purchases?

Apparently, a Piper Jaffray analyst considers that "restored promo pricing" is a magic tool which could take the shares back to $11. Promo pricing indeed may concur to "improved conversion rate of traffic into transactions, and increased E-commerce sales."

What about gross margins and operating cash flows that should shoulder the promo pricing strategy?

November 2013 compares with November 2009 as follows (nine months numbers):

- Gross margin has fallen by 50% ($2,418 vs. $4,790) while operating expenses (OPEX) before depreciation (D) and pension (P) have not followed suit — they decreased by only 5% ($3,110 vs. $3873).

- For every dollar of gross margin at J.C. Penney the operating expenses (less depreciation and pension) were 81 cents during the first nine months of 2009. They were $1.29 per one dollar of gross margin during the first nine months of 2013. If there is not much room for OPEX downsizing then revival simply depends on increasing sales and gross margin? But how to increase both sales and gross margin simultaneously (these days)? There is a vicious circle ...

Bondholders - who issued a notice of default in February 2013 (for a supposed breach of covenants) which they took back on March 2013 (8-K as of March 18, 2013);

OPEX - which are very large for the present level of sales. Closing 33 stores is a drop in the ocean;

Fixed charge coverage ratio. Quote from the latest 10-A: "As of the end of the third quarter of 2013, we had $666 million available for future borrowing, of which $481 million is currently accessible due to the limitation of the fixed charge coverage ratio."

Not related to J.C. Penney, but Warren Buffet said something that fits: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

More to the point, during an interview (Oct. 16, 2013) Buffet commented that J.C. Penney competition was "very, very, very, very tough." And the word "tough" kept popping in almost every of his sentences: "Getting your act together, which JCPenney is doing, is just very tough," "Coming from behind in retail is just plain tough," "The company is tough to run," "Selling 38% new shares is tough."

What honeypots (products, services, discounts, etc.) can J.C. Penney offer which Macy's and so many others could not match on sight?

The customers are bargain hunters, and these days many venues became available to them to shop the best bargain.

Let us reflect to what Bob Pisany from CNBC pointed out in "Half off and you still can't get people in stores:" "Macy's became extremely promotional, beginning in August, and many other retailers couldn't adjust ... Macy's may be the winner relative to J.C. Penney, but the real winner is Amazon. It is adding roughly $10 billion in sales each year, and that is accelerating.... When you add up everyone, there is no growth in the malls, they are just moving share around ... David Berman of Berman Capital, a well-known hedge fund manager that specializes in retail estimates that in the third quarter, 49 percent of total sales growth in U.S. retail came from just three companies: Samsung, Apple and Amazon."

According to the website Stores.org J.C. Penney ranks the 29th place of Top 100 U.S. retailers — behind Target, Costco, Amazon, Sears, Macy's, TJX, Kohl's, Dollar General, Meijer. A roaring crowd, really — and so many more others beyond top 100.

Pressure keeps building from multiple directions and J.C. Penney must play catch up:

- Online merchandising and services. Macy's and Sears do a better online job. Amazon brags about their great search engine, services, customer reviews, Walmart about scan and go, Overstock about low pricing and customer reviews. Except a long, beautiful history J.C. Penney does has not have much to brag about;

Anemic sales growth and gross margins quivering around 30% are prone to prevail more than management was able to foresee due to:

- The bad economics of the business model;

- The company's current shape;

- The market's dynamics.

A (Gross) Estimate of Liquidity

I did this analysis to estimate if J.C. Penney will burn all of its cash or not during the first three quarters of 2014.

Background

According to the company's press release (Nov. 30, 2013): "For the third quarter 2013, gross margin was 29.5% of sales, compared to 32.5% in the same quarter last year. Gross margin for the third quarter was negatively impacted by lower clearance margins due to the overhang of inventory from the first two quarters of the year, higher levels of clearance units sold, as well as the Company's transition back to a promotional pricing strategy as compared to last year's strategy. Notwithstanding, gross margin did improve sequentially throughout the quarter."

- "Comparable store sales grew 10.1 percent over last year," e-commerce sales through jcp.com continued to be strong, running well ahead of last year, consistent with last month's trend;

- "We are pleased with our performance over the Thanksgiving holiday weekend, particularly in light of the continued spending pressures on consumers. The combination of our great merchandise and compelling promotions put us in a position to succeed in a highly competitive environment..." (italics are mine);

- "The traffic and conversion we saw both in stores and online this weekend was exciting for everyone across our organization. We know the environment will remainas competitive as ever, and we are all working to maintain our momentum through the Holiday season" (italics are mine).

Beyond the bragging about the achievements, Ullman's most frequently refers to competition, spending pressure and compelling promotions. Basically, the CEO acknowledges the "formidable days" described by Bob Pisani's article: "Half off and you still can't get people in stores."

On Jan. 8, 2014, that laconic press release said: "The company is pleased with its performance for the holiday period, showing continued progress in its turnaround efforts. Customers responded well to the Company's offerings this holiday shopping season, both in store and online. JCPenney also reaffirmed its outlook for the fourth quarter of 2013, as previously set out in the Company's third quarter earnings release dated Nov. 20, 2013."

The Outlook Was:

Comparable store sales and gross margin expected to improve sequentially and year over year;

SG&A expenses expected to be below last year's levels;

Depreciation and amortization expected to be approximately $165 million;

Interest expense expected to be in line with third quarter;

Capital expenditures expected to be approximately $175 million in the fourth quarter including accrued and unpaid expenditures and approximately $300 million for fiscal 2014;

Inventory expected to be approximately $2.85 billion at year end;

Total available liquidity expected to be in excess of $2 billion at year end.

With regard to fourth quarter 2013, rather than being so tight-lipped, Ullman would have bragged about sales and gross margins if they had shown significant improvement. I think that the likelihood of net sales rising joyfully during 2014 is rather slim, due to the "formidable days" effect described above.

The CEO said gross margin will "improve sequentially and year over year" for fourth quarter 2013. Taking his estimate at face value puts a floor of 29.5% for the fourth quarter 2013's gross margin. I thought it will be difficult to see gross margins above 31.5% given the efforts J.C. Penney has to make (promotions) to recapture lost customers.

OPEX: I used the averages of third quarter 2013 and third quarter 2012 for SG&A, pension, real estate and other, restructuring and income tax expenses as inputs, while for depreciation and interest I picked the numbers from the company's outlook quoted above.

Working capital: The numbers for inventory at year end came from the company's outlook. I carried forward the capex and depreciation as depicted in the year end outlook for the next three quarters. I assumed the company will sell the remaining SPG Group shares it still owned for $30.75 million (205,000 shares x $150/share) during first quarter 2014. For accounts payable year-end as well as for inventory and accounts payable during 2014, I constructed the numbers by using historical patterns (decrease/increase between quarters).

Please, bear in mind that these estimates are bare minimum and based on assumptions which may prove far from what will turn out to be the case in reality. Take it with a grain of salt; they suggest that:

- If the inventory levels will indeed be "approximately $2.85 billion at year end" (a significant cash infusion of $897 million),

- If the vendors are indeed supportive;

- If the company makes no more mistakes.

Although it will burn a lot of cash until fourth quarter 2014, J.C. Penney could walk on its feet to the next holiday season. Then the turnaround could execute if, and only if, the company brings home profits or at least a very clear path to profits...

Of course, things could get worse and the company could file for protection. Or, if with ifs and buts, a new round of (cheap) capital raising will happen, J.C. Penney will enjoy a firmer cushion, but the current shareholders will pay the bill.

Valuation

In a successful turnaround scenario (which is not certain) a more proper value range could be between $2.7 and $3.3 per share — that only if I assume that by 2017 J.C. Penney's revenues stabilize at around $17,000 million and EBIT margin floats around 6% (EBIT margin of 6% is below Macy's but still ambitious considering that during Ullman's stewardship 2009 to 2011, J.C. Penney's EBIT margin was no higher than 3.8% to 5.5%). I assume debt and cash to stay at the same levels as today's. A multiple of maximum 7x to 7.5x could be then applied to EBIT to calculate enterprise value (since Macy's, a better company, traded between 7.7x and 9.2x EBIT during 2009 through 2013, according to Factset). A discount rate of 25% is about what a private equity player would require in normal circumstances. Maybe here it should be higher to compensate for the "formidable days" effect. So I settle for a 30% discount rate.

The current price of $6.99 does not reflect the intrinsic value of the company. Assuming a belief in a successful turnaround scenario, with sales touching $17.0 billion and an EBIT margin of 6% (in four years), a more proper value range for the time being could be between $2.7 and $3.3 per share, which in turn stands for 0.46x to 0.48x EV/Revenue multiples (assuming 2013 full-year sales of $12,100 million). It is a rich sales multiple comparing with 2009 (0.29x) when the company was not distressed, but the above assumptions reflect a belief in a successful turnaround. Which may or may not happen.

Conclusions

Bad economics dent J.C. Penney's business model. The company missed the chance of a significant holiday season revival. Substantially, the miss is owed to the "formidable days" which will continue to generate pressure on margins. Vendors' trust could make or break the company. OPEX are huge for the current level of sales. The company burns cash. It operates on the verge of covenants. So many moving pieces.

I am short J.C. Penney (please, note that I may exit or reverse position without notice).

Comments

Great great article, Gusto.duel. I certainly wish you had put it up earlier. I've learned some great lessons since I jumped on the sinking ship early last year.

I agree with most of the points you laid ou and thank you for put it together. Do you mind exchaing thoughts on the following items:

1. For nine months ending November 2013 OPEX were $3.11 billion. Other things being equal, in order to bring them back to 81% of gross margin (like in 2009) they should amount to no more than $1.955 billion —which is 63% of the actual level achieved for the nine months ending Nov. 2, 2013. Economies of 37% of OPEX make a tough proposition — if such dramatic measures are undertaken sales must be impacted and then merchandise volume, vendor discounts, etc.

Since JCP's business model is highly operational leveraged, which implies every dollar of sales has magnified impact on the margin and bottom line, so I think to bring them back to 81% gross margin, they don't necessarily need to cut 1.96 billion OPEX, but to improve sales by a certain percentage. What do you think?

2. Although I think JCP may have some troubles, shorting it at the current level seems risky to me because there are many possible scenarios and sentiment is so negative. That combined with a high short ratio can make a risky short position as any improvement can trigger sentiment change. The gross margin is barely over 30%, compared to 39% historical average. I'm not saying they can get back to 39% but if you look at Macy's, Kohl, their margins are pretty consistent over time, so to me, 30% margin is more likely unsustainable. And if margins improve, the impact on EBIT will be magnified too because of the operating leverage. This will in turn has a big impact if you use EV/EBIT multiple as a base to your valuation.

Just some thoughts. I am long JCP btw, but as I admitted in my article, I am not proud of that decision:)

1 - I agree, but - probably Mr.Ullman thought so and his bet was that by restoring the "good ways" (considered obsolete by Ron Johnson) will be able to raise sales and get back to profitability. I think the biggest issue JCP confronts is the environment and the lack of ability to differentiate. That will continue to press gross margins - they can mainly compete on price. The level of sales is also affected by these factors. The other issue is that by losing sales volume JCP loses bargaining power with suppliers, hence lower discounts and again pressure on gross margins.

Restoring the good old ways is not enough.

2- You are right with Macy's, Kohl - I wonder if they source their merchandise from different suppliers. They are a bit bigger (Sales- Macy's $27.6 billion, Kohl $19.3 billion) so they may enjoy a bit more discount from suppliers. I did not check on the site (not living in US) which might help (remember Warren Buffet's restaurant due dilligence on American Express). According to this article J.C. Penney: A Bridge Too Far it appears that JCP does not even offer the best price. However, maybe Macy's and Kohl enjoy a small premium on the sales price, too. JCP itself was 40% gross margin in 2009. The question is - can JCP raise prices/sell more so that OPEX become a reasonable percentage? Hardly. So, unless I am wrong (...) gross margins will be under presurre.

On entering a short position at these levels I cannot comment. There are some classic short ingredients: high debt, tough competition, no differentiation, management seemingly overwhelmed. To make it safer I would have liked to see fraud, a higher price, etc. I think that in the end - short term -it all depends on vendors - they can kill the company if ask for cash on delivery or more LC's. Longer term If the management acts very radical mayby they can at least cut OPEX (if there is more room or not to cut it I do not know considering both Johnson and Ullman already did it), if not increase sales...

The valuation is extremely sensitive as you noted. I was also tempted by the long story after Ackman. Fortunately, I was not convinced. I will be more convinced of the short story when I see the results.

Thanks for the detailed and well thought-out answers. I don't know the future of JC Penney but I've committed to learning from this experience either way. Wish you best with the short position and thanks again for an excellent article. This is my of my favorites on gurufocus.

" Standby letters of credit, which totaled $481 million, are issued as collateral to a third-party administrator for self-insured workers’ compensation and general liability claims. The remaining $25 millionare outstanding import letters of credit."- This looks good for JCP which seems to retain the trust of its suppliers.

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